Form 1065: Cash Books, Accrual Tax Return

Technical topics regarding tax preparation.
#1
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New client has been in the food manufacturing business and averages about $80,000 in gross sales each year.

They keep excellent books, using the cash method.

Their prior preparer insisted they file under the accrual method "because they have inventory", so they have been filing as such.

The preparer would make an adjusting entry to add the accounts receivable to "other income" and also make an entry on Schedule M1.

And that's it.

Now I'm engaged to prepare the return and I have some concerns.

1) Shouldn't the previous year's receivables also be included in the adjustment (previous year's adjusted out, current year's adjusted in)? Note that this would create a very favorable deduction for them for 2019.

2) Do I need to suggest they keep their books in accrual instead of cash?

3) Should I file form 3115 and switch them to cash? Does this increase their audit risk?

But would switching eliminate their favorable deduction this year?
 

#2
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Let’s say Year1 cash basis profit is $100k. But there’s $10k of A/R @ 12/31/Year1. So the tax return shows $110k of profit on the accrual basis.

In Year2, let’s say cash basis profit is $80k. Assume all $10k of the 12/31/Year1 A/R was collected in Year2 and is imbedded in the $80k number. Assume $0 A/R @ 12/31/Year2…so bookkeeper would have us add $0 to the Year2 cash basis profit.

Lifetime, we’ve reported $190k of income on the accrual basis…but we’ve only made $180k on the cash basis…and we have $0 A/R @ 12/31/Year2. Lifetime income should be the same in this instance. The $10k of 12/31/Year1 was reported in Year1 on the accrual basis and was duplicated in Year2 on the accrual basis because the bookkeeper didn’t adjust it out in Year2.

So the answer to #1 is obviously “yes.” Each year, we need to account for the “change” in A/R…not just ending A/R.

#2 is up to you. It can be easily done in QB’s at each year-end: Just input an actual invoice into the A/R module with the customer listed as “Dummy.” You want to use the A/R module here so that when you click over to cash basis, the Receivable disappears. This allows you to compare Cash and Accrual P&L’s to double-check your conclusions. For bozo clients like this, I wouldn’t keep up with A/R and A/P all year…I’d just use one dummy entry for each at each year-end.

As to #3, you could switch them, and it doesn’t increase audit risk, I’d say.

Who knows if they’ve been handling A/P and Inventory right…and all those accruals that true accrual taxpayers are supposed to make.
 

#3
Coddington  
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I agree with Jeff. You need to nail down what was going on with A/P and inventory. Unless they are a tax shelter, regardless of whether they are actually on an accrual or a hybrid method, they should qualify to move to the cash method under the new small taxpayer method change procedures. If that is truly $80,000 top line, I have no idea why the prior preparer thought they should be on accrual. Are they part of a larger group of controlled trades or businesses at the single employer level?
-Brian

Director of Tax Accounting Methods & Credits
SourceAdvisors.com

Opinions my own.
 

#4
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Thanks for the replies - these answers are for exactly what I was asking.

(Not a tax shelter or part of a group - great and detailed inventory report.)

But now as I take a second look at the prior year return, I see that the cash box is checked.

The books are certainly in cash.

I don't understand why the prior CPA would make that adjustment. :?:
 


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